How to Get Ready for a Quality of Earnings Report

Soon after you sign a letter of intent, a buyer’s accountants will ask for your numbers. They want to know if your profit is real. You can prepare for that review, and the work pays off in a smoother deal.

What is a quality of earnings report?

A quality of earnings report, or QoE, is an accounting review that tests whether a company’s earnings are accurate and will repeat. Buyers use it to confirm the profit number behind their price.

Our guide on quality of earnings and the glossary entry on quality of earnings cover the basics.

An audit and a QoE ask different questions. An audit asks whether statements follow accounting rules. A QoE asks whether the profit is real and will last. That matters because price is usually a multiple of EBITDA.

Why do buyers ask for one?

Buyers ask for one because price depends on earnings, and small errors become large price changes.

Law firm Lindabury writes that “Nearly every institutional deal includes an independent Quality of Earnings review.” Alpine Investors lists “Quality of earnings (finance and accounting)” as one workstream of due diligence, next to operations, tax and legal reviews.

CLA reports that “Quality of earnings (QoE), EBITDA discrepancies, and other diligence findings together account for nearly half of all failed transactions.” In plain terms, financial surprises can end a deal or lower its price. Your goal is to find them first.

What does a QoE report look at?

It looks at your profit, your costs, your cash and your balance sheet. The table shows the usual areas and what to prepare.

BD Emerson describes why small companies draw extra attention: “Many have cash-basis books, no audit, owner expenses running through the business, and related-party rent.” A reviewer will normalize those items so the earnings figure reflects the business alone. See the glossary entries on add-backs and adjusted EBITDA.

How can you get ready, step by step?

Work through these steps over 12 to 24 months if you can, or compress them if your timeline is shorter.

1. Close your books every month. Finish within a few weeks of month end, and reconcile bank and credit card accounts.
2. Move to accrual accounting if you use cash. Buyers compare companies on one basis. An outside accountant can help.
3. Separate personal costs. Stop running personal expenses through the company. Each one becomes an add-back you must prove.
4. Build your add-back schedule. For each add-back, keep the invoice, the reason and a note on why it will not return.
5. Pay owners and family at market rates, on paper. Document what a replacement would cost.
6. Review revenue by customer. Know your largest customers and how long each has stayed.
7. Map your working capital by month. Seasonal swings can be large. Know your normal level. See the glossary entry on working capital adjustment.
8. Fix known problems. Unrecorded liabilities, late tax filings and missing contracts all raise questions.
9. Assemble a data room. Keep statements, tax returns, contracts and schedules in one organized place. See data room.
10. Ask your CPA to review your work. A fresh set of eyes finds gaps.

Should you order a sell-side QoE?

A sell-side QoE can help, and CLA recommends it. CLA says that “The most effective strategy for maintaining seller confidence is conducting a sell-side quality of earnings analysis before going to market.” The seller commissions the report and finds problems before a buyer does.

There are trade-offs. A sell-side report costs money, and a buyer may still run its own review. Ask your adviser whether it makes sense for your size and your timeline. Our guide on working with an investment banker or adviser can help you frame that talk.

What happens if the QoE finds a problem?

A finding does not end a deal by itself. It usually leads to a talk about price or structure.

If the reviewer lowers your adjusted EBITDA, the buyer may lower its offer. If a gap is still unclear, the buyer may propose an earnout or an escrow to cover the risk. Tell your adviser early so you can explain each item with records.

For the wider picture, read our guide on due diligence for owners and our post on how to tell if your company is ready for private equity.

Next step

Read our deal criteria to see what Capstreet looks for in solid financials. When you want a confidential conversation, contact Capstreet, call 713-332-2700 or email connect@capstreet.com.